The Chinese Banking System Is Seriously At Risk

A couple of weeks ago, I published a column outlining my doubts about the
health of China’s banking system in the lead-up to the
Agricultural Bank of China (AgBank)’s IPO. Given the
lackluster performance of that share launch – despite
the considerable political capital Beijing mobilized
behind making it a success – it seems I was hardly
alone in my concerns.

Now some concrete data is starting
to emerge regarding the potential size of the problems
that may be lurking on China’s bank balance sheets — in
particular, the losses that may be incurred from risky stimulus
loans made to development entities (known by some
as LGFVs, or Local Government Financial
Vehicles) sponsored and supposedly guaranteed by provincial
and local governments. Earlier this year, China’s central
government nullified those guarantees, noting that local
authorities often lacked the financial wherewithall
to stand behind them. The China Banking Regulatory
Commission (CBRC), which had previously been touting such loans
as safer-than-safe, launched an internal study to get
some handle on just how big a problem they have on their
hands.

According to analysts at Bank of America-Merrill Lynch (BoA-ML),
as well as a report published today by Bloomberg, inside
sources at the CBRC say the study has been concluded and some
findings reached. According to them, at the end of this
June, LGFV loans amounted to RMB 7.7 trillion (US$1.1 trillion),
or 16.2% of all loans in the banking system. (Rough
estimates I’ve heard had placed LGFV loans at 40% of all of new
loans made last year and this year, which may still be possible,
but there is nothing in the new data to confirm it).

Of these LGFV loans, 27% were found to have funded projects with
sufficient cash flow to repay the loans. 50% must rely on
“alternative sources” for loan repayment (which I take to mean
either seizing collateral or invoking the public
guarantee). 23% are categorized as “facing high credit
risks (ie invalid qualification of borrowers, invalid guarantee
by local governments, or loans misappropriated).” According
to the BoA-Merrill analysts, if those 23% “high risk” loans
(totaling RMB 1.7 trillion) were downgraded to NPLs and assigned
20% provisions, ”it would lead to 74bp of extra credit cost
for the sector, or some 30% cut to [bank] earnings.” Or as
Andrew Peaple of the Wall Street Journalpoints out, the roughly US$230 billion in new
bad debt would amount to more than three times the US$67 billion
in NPLs currently recognized by China’s banks.

Andrew argues that while “pretty sobering,” the figures
aren’t quite as bad as they sound, because “even a
fourfold increase in the amount of bad loans in the system would
keep their level, as a proportion of overall lending, far off of
highs seen a decade ago, when Chinese banks needed a major
government-led bailout.” As I mentioned to him
yesterday, though, don’t find much comfort in that line of
thinking, for two reasons.

First, while it’s tempting to focus exclusively on the 23%
“bad loan” category, these are just the worst of the bunch, the
ones that are clearly rotten. I find it remarkable
that only 27% of LGFV loans can be repaid from project cash
flows. That suggests that the vast majority of
such loans were not financially viable (that doesn’t mean the
projects weren’t worth doing, in a broader sense, since some of
the projects may have had positive social and economic
externalities — but the point remains, from a commercial lending
point of view, these were not good investments).

When we talk about 50% of the loans being payable by
“alternative” means, we’re either talking about a primary
default, where the local government has to deploy its own
revenues or assets to step up to its guarantee, the seizure of
often-illiquid collateral such as undeveloped land owned by the
same local governments (which they depend on for as much as 1/3
of their future revenues), or some kind of rescheduling or
renegotiation of the debt (quite likely, since all parties are
state entities, and a political deal would likely need to be
struck to avoid any of them suffering too much
embarassment). None of these are “good” outcomes, and may
involve losses for the lender, the guarantor, or both. So
the US$230 billion figure is by no means a cap on the LGFV losses
that might eventually be sustained, one way or another.

Second, loans to LGFV aren’t the only risky or inappropriate
loans that were made during last year’s lending boom.
They’re just one lending category that most alarmed the
Chinese government because (a) it had been assumed to be
“safe” and (b) the identity of the borrowers posed a
political as well as financial dilemma.
There are plenty of other categories — loans
to property developers, to industries with significant
overcapacity, to overextended home buyers, to businesses that
diverted the funds to stock and real estate speculation — that
may pose equal or greater risk of loss. In short,
the LGFV figures coming out of CBRC could just be the tip of
the iceberg — the first wave, if you will, crashing against the
shore. If the pattern persists, and subsequent revelations
indicate 20-25% NPL rates for all or most of last year’s runaway
lending, the resulting hole in the banks’ balance sheets will be
a hard to ignore or easily fix.

It’s worth point out, by the way, that I started warning about
all of this way back in May of last year, in an op-ed I wrote
for the Wall Street Journal, which you can read here.

Tomorrow, in Part 2 of this post, I’m going to highlight a recent
article in Knowledge @Wharton that focuses on the profound
structural challenges facing Chinese banks as they try to salvage
the situation and get back on the track to reform.